In part one of the Fixed Deposit Vs Mutual Funds comparison, we analyzed the existing and new ways to invest in Debt Mutual Funds. Now its time to dig deeper and learn why one should invest in Debt Funds, What are the risks in debt Funds and how these risks can be countered. Also, let’s see how taxation can be addressed and be made more efficient.
After Demonetization, Indian banks have sharply pruned the interest rates they are offering on deposits in the last one year. SBI starts and other banks also find a room to reduce the rates.
Why Mutual Funds for Debt Investments?
Debt fund managers, through active management of the portfolio, can deliver a better return than passive instruments like fixed deposits.
These returns are tax efficient. Means legally you can save tax outgo, so it will increase returns in hand.
Differences: fixed deposit vs mutual funds comparison
Before you start rejoicing and start investing in these funds there are few points which one must know and accept.
The first thing this, you need to understand is these funds do not deliver returns like dairy milk pieces. Identical in shape, equally divided and taste.
The funds have swings and period where returns will be static.
Funds like Gilt Funds, Long Term Income funds, Dynamic Funds & Short Term Income Funds may even go negative on a bad market day.
Most of their returns earned are from falling interest rates. So more fund is price sensitive like a Gilt fund more chances of its going up & down.
So on the flip side, these funds also make the most losses when rates rise.
Credit opportunities funds may not see their returns swinging as sharply as long-term gift funds or income funds. Returns for credit –opportunities funds hovered between 7 % and 9.55% annually in the last five years. But as these funds earn higher returns by investing in lower-rated corporate bonds, and NAVs can suffer sudden jolts if a bond issuer defaults or delays repayment.
Dynamic bond funds use a combination of both long-dated bonds and lower- dated ones. They can increase or decrease maturity to increase their returns. Their returns are volatile as long-term gilt funds or credit opportunities funds.
Returns on hybrid debt-oriented funds (Equity Savings/Arbitrage or MIPs) look tempting as equity has worked for them in last 5 years. But when markets correct equity component in these funds can even deliver negative returns.
Risk In Investing Debt Funds
Comparing Bank FDs (or Post Office small saving schemes) is like comparing Apples to Oranges.
There is huge risk investing in products sensitive to interest rates. These are Gilt Funds, Income Funds, Dynamic Bond Funds & Short Tern Income funds to some extents.
While debt funds may not be as risky as equity funds, a part of your initial investment can erode nonetheless. This is because these funds invest in various fixed income instruments such as government bonds, corporate bonds and other money market and short-term debt instruments.
The NAV of your debt fund can thus rise or fall along with the underlying bond prices.
See how 10 Years Bond Yield has risen in last 2-3 months.
As I said the relationship is inverse, so these funds have delivered negative returns. Yes, capital erosion has happened. Look here at some funds:
| Fund | 1 Day | 3 Days | 1 Week | 2 Weeks | 1 Month | 3 Months |
| Aditya Birla Sun Life Income Plus – Direct | -47.10 | -9.01 | -12.20 | -6.40 | -0.95 | -1.34 |
| BNP Paribas Corporate Bond Fund – Direct | 9.55 | 5.73 | 3.52 | 4.89 | 6.14 | 5.69 |
| Canara Robeco Income Scheme – Direct | -48.18 | -16.82 | -15.15 | -6.97 | -0.24 | -0.20 |
| DHFL Pramerica Premier Bond Fund – Direct | 9.14 | 6.40 | 2.32 | 4.24 | 5.59 | 5.00 |
| DSP BlackRock Bond Fund – Direct | 6.27 | 0.22 | -1.23 | 0.92 | 6.30 | 5.64 |
| Franklin India Dynamic Accrual Fund – Direct | 8.97 | 6.39 | 5.14 | 6.62 | 8.75 | 7.92 |
| Franklin India Income Builder Account – Direct | 5.93 | 3.99 | 3.69 | 5.60 | 7.63 | 6.44 |
| HDFC Income – Direct | -56.82 | -20.48 | -17.95 | -9.64 | -0.19 | -2.10 |
| HSBC Income Fund – Invtt Plan – Direct | -36.34 | -8.20 | -11.18 | -7.27 | -1.70 | -2.97 |
| ICICI Prudential Income Fund -Growth – Direct | -28.83 | -12.76 | -13.98 | -6.40 | -0.02 | -1.68 |
| IDFC SSIF – Invt. Plan – Plan A – Direct | -30.80 | -4.11 | -10.80 | -1.28 | 2.38 | -1.30 |
| Invesco India Active Income Fund – Direct | -40.29 | -15.79 | -18.73 | -9.41 | -1.30 | -2.55 |
| Kotak Bond – Plan A – Direct | -64.15 | -20.87 | -18.68 | -6.10 | 2.83 | -2.06 |
| L&T Triple Ace Bond Fund – Direct | 10.98 | 1.97 | -0.51 | 2.62 | 4.44 | 4.01 |
| LIC MF Bond Fund – Direct | -21.28 | -2.92 | -8.21 | -5.70 | -0.51 | -0.07 |
| Reliance Income – Retail – G P – Direct | -29.30 | -9.72 | -12.95 | -6.66 | -0.54 | -1.21 |
| SBI Magnum Income – Direct | 1.27 | 4.13 | -1.07 | 1.17 | 3.61 | 2.86 |
| Sundaram Bond Saver – Reg – Direct | 1.89 | 0.68 | -1.35 | -0.85 | 4.75 | 4.11 |
| Tata Long Term Debt Fund – Direct | -8.19 | -2.37 | -7.39 | -1.91 | 2.07 | 1.65 |
| UTI Bond – Direct | -11.09 | -2.53 | -11.57 | -5.48 | 2.14 | 0.17 |
Noticed the negative returns for some funds?
Corporate bond funds bet on the credit risk of the bonds in the portfolio. A wrong credit call can cost huge. For instance, if a company that has issued the bond defaults on its interest or principal repayment, the debt fund’s portfolio to that extent is written off. This will impact the NAV of the debt fund.
Even if a bond does not default, rating agencies can downgrade the rating on these bonds owing to several reasons. This decreases there price in the markets. This means a reduction in the value of the fund’s NAV. In last 2 years on more than 5 occasions, this kind of situation has risen.
This is why investors jumping blindly from Bank FDs to debt funds need to choose their debt category based on their risk profile, rather than past returns.
So do not expect Dairy Milk chocolate pieces.
Taxation
When debt (or hybrid debt) fund declare and pay out dividends they cut 28.3 % as Dividend Distribution Tax. You do not directly pay this tax, as you get net after deduction. But it is sharing returns with the government. Suffering this 28.3 % tax on your income can be loss-making for an investor in 10 or 20 % tax bracket.
So What to Do?
So if you are a conservative investor in lower tax brackets, setting up Systematic Withdrawal Plan (SWP) to redeem a fixed sum from the scheme each month is a better option. The SWP gets you a predictable cash every month or quarter and also sharply reduces your tax outgo.
If you are conservative investors whose main objective is to earn steady returns, you should be looking for a fund with low-risk portfolios. This means funds with good credit papers & short-term maturity. You can look at corporate bond funds and MIPs if you can hold equity for long-term (5-year plus).
To ensure low volatility, choose funds which have fared consistently well over a seven-eight year time frame (at least two rate cycles).
Debt funds can either follow a strict duration, accrual or credit call or blend the two to come up with different strategies. Long-term gilt funds that primarily invest in government bonds carry a higher interest rate risk. If you want to bet on falling rates, you can invest in such funds. However now is not that time.
On the other hand, if you are risk-averse and do not want to bet on interest rate movement, you can go in for dynamic bond funds that switch between long and short-term debt instruments.
If you want to take a credit call, there are many debt funds, ranging from those investing in low-rated bonds to those that invest in high-rated bonds. You can choose between these funds based on your risk appetite.
Best way consult an expert or financial planner. And that is why I said FD & Mutual funds are a class apart. They do not hand in gloves or related. One is a vanilla and other is a cocktail.
Hope you liked this article on fixed deposit vs mutual funds comparison and this will help you in managing debt funds in your portfolio.
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